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IRS Tightens Penalty Relief

By Mark S. Heroux, J.D., and Colin J. Walsh, J.D., Chicago

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Tax Section

Editor: Alan Wong, CPA

Procedure
& Administration

Recent IRS actions
suggest a movement away from granting penalty
relief. The IRS has modified its first-time
abate (FTA) administrative waiver policy, making
an FTA more difficult to obtain. Moreover, a
number of recent court cases suggest that the
IRS will be less willing to resolve penalty
issues when there is an underpayment of tax from
undisclosed financial assets. Recent budget
cuts, furloughs, and negative press have
exacerbated the trend by significantly
decreasing IRS resources, resulting in slower
responses to taxpayer inquiries.

Failure-to-File and Failure-to-Pay
Penalties and FTA

Check the
preceding tax years (at least three) for payment
patterns and the taxpayer’s overall compliance
history. The same penalty, previously assessed
or abated, may indicate that the taxpayer is not
exercising ordinary business care. If this is
the taxpayer’s first incident of noncompliant
behavior, weigh this factor with other reasons
the taxpayer gives for reasonable cause.

As a practical matter, the IRS has routinely
granted FTAs for a variety of failure-to-file,
failure-to-pay, and failure-to-deposit
penalties. It is worth noting that the IRS
generally applies FTA on a
penalty-by-penalty basis. That is, a
taxpayer’s FTA for failure to file in one year
does not preclude that taxpayer from obtaining
an FTA for failure to pay in the next year.
Practitioners, however, must always be mindful
that FTA is a discretionary policy. That is, FTA
is not required by law.

On April 5, 2013,
the IRS updated the FTA policy, stating,
“Penalty relief under FTA will be limited to
those taxpayers that are current with filing and
payment requirements” (IRM Procedural Update,
SBSE-20-0413-0690 (4/5/13)). Thus, taxpayers
must be current with all filing and payment
obligations to obtain an FTA. It is noteworthy
that the procedural update considers a taxpayer
current with payment obligations if that
taxpayer has established an installment
agreement. It is more noteworthy that many
front-line IRS employees apparently conclude
that a taxpayer whose return is on extension is
not current with filing requirements.

Accuracy-Related Penalties and
FTA

The IRS generally will not apply an
FTA to Sec. 6662 accuracy-related penalties,
even though the fact that a taxpayer has never made an
error on a tax return suggests that this first
error was an honest mistake and an FTA is
appropriate. Unfortunately, these types of
arguments have fallen on deaf IRS ears. Indeed,
some practitioners have been told that an FTA
does not apply to accuracy-related penalties,
and the IRM procedural update specifically
excludes Sec. 6662 from the penalty Code
sections eligible for an FTA.

Taxpayers
that seek to abate accuracy-related penalties
should establish reasonable cause using other
reasons than that it is a first-time occurrence.
These taxpayers may still point to a clean
compliance history when requesting penalty
abatement; however, an FTA should not be
strictly relied upon. Taxpayers may instead
point to a variety of other factors to show
reasonable cause, including but not limited to
the use of ordinary business care, reliance on
written IRS advice, and death or serious
illness. Each of these factors can establish
reasonable cause without any reference to
FTA.

Civil Penalties and
Recent Case Law

The IRS has recently
increased its pursuit of civil penalties for
taxpayers who fail to file various international
tax forms, such as Form TD F 90-22.1, Report of Foreign
Bank and Financial Accounts (FBAR). The
Fourth Circuit Court of Appeals and the District
Court of Utah recently upheld civil penalties
for willful failure to file FBARs in Williams,489 Fed.
Appx. 655 (4th Cir. 2012), and McBride, No.
2:09-cv-378 DN (D. Utah 11/8/12), respectively.
Question 7a of Schedule B on Form 1040 asks
taxpayers whether they have an FBAR filing
requirement. In both cases, the courts pointed
to the fact that the defendants had signed Forms
1040 under penalties of perjury and incorrectly
answered “no” to Question 7a.

The Fourth Circuit referred to the concept
of “willful blindness,” “where a defendant was
subjectively aware of a high probability of
the existence of a tax liability, and
purposefully avoided learning the facts [that]
point to such liability” (quoting Poole, 640 F.3d 114 (4th Cir. 2011)). The IRS
now uses willful blindness to support the
proposition that any individual who fails to
file an FBAR and answers “no” to Question 7a
is subject to civil penalties (IRM §4.26.16.4.5.3). Whether Williams and McBride support this strict proposition is
questionable. The defendants in Williams and McBride engaged in egregious conduct in addition
to answering “no” to Question 7a, as both
defendants conceded that they intentionally
took steps to evade the payment of tax.

For instance, the defendant in Williams was an international tax attorney who set
up bank accounts in Switzerland. The defendant
stated:

I also knew that I
had the obligation to report to the IRS and/or
the Department of the Treasury the existence of
the Swiss accounts, but for the calendar year
tax returns 1993 through 2000, I chose not to in
order to assist in hiding my true income from
the IRS and evade taxes thereon.

Likewise, the defendant in McBride
admitted to creating a financial plan designed
to hide foreign assets. Courts have not yet
ruled on a case in which the defendant was truly
unaware of the FBAR and mistakenly answered “no”
to Question 7a. The IRS nonetheless maintains
its position that Williams and
McBride
dictate that civil penalties should apply to the
“oblivious taxpayer.”

Fraud
Penalties and Recent Case Law

Two recent Tax Court cases, Vanover, T.C. Memo. 2012-79, and Bohannon, T.C. Memo. 2013-122, can serve as
measuring sticks for situations in which
courts will uphold fraud penalties. The Tax
Court upheld fraud penalties in Vanover, a case in which the petitioner deducted,
on a business tax return, a number of personal
expenses, including an automobile collection,
a home mortgage, and personal utilities. The
petitioner provided incomplete documents to
his tax return preparer, did not cooperate
during the IRS’s examination, and had
extensive dealings in cash.

The
petitioners in Bohannon also
deducted a number of personal expenses on a
business tax return, including personal
architectural services, cabinets, and a baby
sitter. However, the Tax Court did not uphold
fraud penalties, noting that the petitioners
kept meticulous records and were fully
cooperative with the IRS examination. The Tax
Court stated, “Simply put, petitioners made
mistakes recording their expenditures, did not
intend to evade tax, and are not liable for
fraud penalties.”

It is significant that
the IRS pursued fraud penalties in Bohannon, a
case in which the petitioners seemingly did not
engage in any egregious activity. Moreover, in
Bohannon, the
Tax Court made clear that failure to cooperate
with IRS examinations suggests fraudulent
intent.

Conclusion

The above-mentioned changes to the FTA policy
and recent cases suggest that the IRS has
increased its pursuit of penalties. As the
federal government continues to experience
furloughs and budget cutbacks, the IRS may view
penalties as an important source of revenue. At
a minimum, these changes mean increased costs to
work with the IRS to abate penalties.
Practitioners should be mindful of these recent
changes when advocating for clients.

EditorNotes

Alan Wong is a senior manager–tax with Baker
Tilly Virchow Krause LLP, in New York City.

For additional information about these items,
contact Mr. Wong at 212-792-4986, ext. 986, or
awong@bakertilly.com.

Unless
otherwise noted, contributors are members of
or associated with Baker Tilly Virchow Krause
LLP.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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